Friday, May 13, 2011

(This is a repeat of yesterday's post which seems to have disappeared)

Inflation at the producer level continues to move higher, whether or not you include food and energy. Over the past six months, producer prices are up at a double-digit rate: 11.5% annualized. Core prices are up at a 3.1% annualized rate over the same period.

Compare these numbers to what we saw during the 10-yr period ending Dec., 2003, in which core producer price inflation averaged just 1% per year, and the headline PPI averaged 1.6% per year. That same period saw the headline CPI average 2.4% per year, and that was the lowest level of inflation in a 10-yr period that we had seen since the 1960s. Not coincidentally, the Fed was following a relatively restrictive monetary policy during that period, during which time the real Federal funds rate averaged 2.4% per year (today it is -2%), the dollar was generally appreciating, and commodity prices were for the most part unchanged.

The recent decline in oil prices undoubtedly will result in a decline in the headline PPI in the months to come (thank goodness, otherwise we'd be talking about double-digit year over year producer inflation), but it won't necessarily cause the core PPI to decline. Indeed, as I've noted before, it is noteworthy that core prices have been picking up of late even as oil prices have soared: if the Fed were tight enough to keep inflation at bay, then a big rise in oil prices would have resulted in a decline on average in non-oil prices. The fact that both headline and core PPI inflation have been picking up for the past 18 months is good evidence that monetary policy is indeed accommodative.

Easy money works first at the commodity and producer level, and eventually makes its way to the consumer level. By the time easy money shows up in the consumer price index, it's been out in the wild for many months and even years. And by that time it's almost too late to do anything about it. Gold and commodity price speculators for years have been anticipating the rise in inflation that is now underway. The only question now is whether inflation will prove to be as high as the runup in gold and commodity prices is assuming. Unfortunately I don't know the answer to that question. But I do know that deflation risk at this point is just about zero, and that nominal GDP is going to be picking up significantly in the years to come, and that is going to prove to be fertile ground for cash flows for all sorts of companies. That should be good news for equity investors, for holders of corporate and emerging market debt, and for owners of real estate.

This post by Krugman shows inflationary expectations, as measured by TIPS-Treasuries spreads, is now falling.

Some observers have been warning about inflation for years. Yet where is it?

How do you get inflation with declining unit labor costs and 6 percent steady growth in M2? With falling real estate values? With the blow-off in commodities, even that sector will not be doing much for a while

BTW, it was incorrect to ever cite commodities as a long-term inflationary factor. Unlike equities, a rally in commodities has a ceiling. Where (in a boom) a hot stock can go to 20, then 30, then 40 times earnings, in commodities you reach a point where consumers stop buying.

I might pay 50 times earnings for a hot stock if I thought it had a great future. I will not pay $10 for a gallon of gasoline. I will bike to work.

Ergo, the fears attached to commodities inflation have always been misplaced.